FASB Tackles Plans to Update Software Cost Accounting Guidance

According to the proposed Accounting Standards Update (ASU) the FASB issued on Tuesday, feedback the board received in 2021 from preparers and accountants indicated that the accounting for software costs should be a top priority for the rule-makers.

Those stakeholders encouraged the FASB to better align the accounting with how software is developed because the current guidance is outdated and lacks relevance given the evolution of software development.

The proposed ASU states:

Specifically, many entities have shifted from using a prescriptive and sequential development method (for example, waterfall) to using an incremental and iterative development method (for example, agile). Stakeholders stated that the current internal-use software accounting requirements do not specifically address software developed using an incremental and iterative method. As a result, stakeholders stated there are challenges in applying the current internal-use software guidance, which has led to diversity in practice in determining when to begin capitalizing software costs.

Considering this feedback, the Board decided to make targeted improvements to the internal-use software guidance. Specifically, the Board decided to make targeted improvements to Subtopic 350-40, Intangibles—Goodwill and Other—Internal-Use Software to improve the operability of the recognition guidance considering different methods of software development and to enhance the transparency of cash outflows for capitalized software costs.

Under the proposal issued by the FASB, all references to a prescriptive and sequential software development method—referred to as “project stages”—would be removed throughout Subtopic 350-40. The proposed amendments would specify that a company would be required to start capitalizing software costs when both of the following occur:

• Management has authorized and committed to funding the software project, and
• It’s probable that the project will be completed and the software will be used to perform the function intended—referred to as the “probable-to-complete recognition threshold.”

In evaluating the probable-to-complete recognition threshold, a company may have to consider whether there is significant uncertainty associated with the development activities of the software, according to the FASB. Factors to consider in determining whether there is significant development uncertainty include whether:

• The software being developed has novel, unique, unproven functions and features or technological innovations.
• The entity has determined what it needs the software to do (for example, functions or features), including whether the entity has identified or continues to substantially revise the software’s significant performance requirements.

The proposed amendments also would require a company to separately present cash paid for capitalized internal-use software costs as investing cash outflows in the statement of cash flows.

The proposed ASU states:

Under current GAAP, entities are required to capitalize development costs incurred for internal-use software depending on the nature of the costs and the project stage during which they occur. Stakeholders have said that applying this guidance can be challenging because entities have trouble differentiating between the project stages, particularly in an iterative development environment. The amendments in this proposed Update would improve the operability of the guidance by removing all references to software development project stages so that the guidance would be neutral to different software development methods, including methods that entities may use to develop software in the future.

Many investors have noted that transparency about an entity’s software costs could be enhanced and, in certain circumstances, additional information could be decision useful. The amendments in this proposed Update would enhance transparency for investors, lenders, creditors, and other allocators of capital (collectively, “investors”) by requiring entities to classify cash paid for software costs accounted for under Subtopic 350-40 as investing cash flows in the statement of cash flows and to present those cash outflows separately from other cash outflows.

The FASB encourages stakeholders to review and provide comments on the proposed ASU by Jan. 27, 2025.